External grants are important for low-income countries, particularly
in their efforts to reach the Millennium Development Goals (MDGs) and
combat the HIV/AIDS pandemic. Some critics contend that IMF-supported
programs discourage higher grant flows intended to support poverty-reducing
spending. In fact, the IMF strongly supports higher external grants, and
works with its member countries to ensure that they are used to best advantage.

Why are external grants important for low-income countries?

Low-income countries will require an estimated $30-70 billion per year
in additional government spending to reduce poverty and achieve the Millennium
Development Goals (MDGs).1 This increased
spending must be financed through some combination of higher domestic
revenues, external assistance and government borrowing.

Higher levels of external grants and their more effective use are important
elements of the Monterrey Consensus to fight poverty and reach the MDGs
in low-income countries. Especially for countries that are at risk of
debt distress from further borrowingeven on concessional termsincreased
grant financing enables higher poverty-related spending without incurring
additional debt. The IMF is a strong advocate for increased external grants
to these countriesincluding from the Global Fund to Fight AIDS,
Tuberculosis and Malaria and the Education For All Initiative. The key
is to ensure that this increased funding is well used.

Challenges in absorbing additional grant inflows

To make the best use of additional grants, countries need to confront
a number of economic challenges. These include ensuring effective administration
and absorption, maintaining macroeconomic stability, and formulating budgets
under uncertainty.

First, a recipient government must develop the abilityor "capacity"to
effectively use additional grants. In many low-income countries, public
administrative capacity is low. Institutions for delivering services may
be inadequate, as may systems for planning and monitoring. It may also
be difficult for countries to expand spending rapidly in some areas if
there is a limited supply of skilled labor. For example, a lack of trained
teachers could impede rapid expansion of the school system. Or, an expansion
of HIV/AIDS treatment and prevention programs could draw away the limited
number of qualified health professionals providing other health services.
Moreover, some countries suffer from poor governance. Lack of transparency
in government operations, lax spending controls, and weak legal frameworks
can all contribute to an environment where resourcesincluding external
grantsare diverted or misused.

Second, government spending plans must be formulated in light of the
potential volatility and unpredictability of grants. Disbursements of
grants depend on a host of factors, including political developments and
progress in meeting conditions set by donors. But volatile grant flows
can increase fiscal uncertainty and make long-term planning difficult.
For example, if the duration of grant financing is uncertain, a government
faces great risks in hiring new staff on a permanent basis. Grant-financed
spending may also give rise to future expenditure commitments that need
to be met even after grants are no longer available. For example, grants
that finance the building of new roads or improvements to port facilities
may not include funds for maintenance after the projects are completed.

Third, a country must be capable of absorbing additional aid flows in
a way that does not undermine macroeconomic stability, which is critical
for long-run growth. Grant inflows could lead to higher inflation and
real exchange rate appreciation, both of which could be detrimental to
growth and efforts to reduce poverty. For example, consider external assistance
that is used to finance higher spending on domestically produced goods
and services (such as the construction of roads or schools), rather than
higher imports. This increased domestic demand, especially in combination
with labor force or other supply constraints, would likely put upward
pressure on domestic prices, at least in the short-run. Higher domestic
inflation, in turn, typically leads to an appreciation of the real exchange
rate, thereby reducing the competitiveness of a country's exports. The
poor are often hardest hit by these changes, especially if they are producers
of exports (as is often the case in agricultural economies).

How the IMF supports the effective use of grants

The IMF is working on several fronts to help its low-income member countries
meet these challenges and incorporate increases in government spending
in a way that minimizes the risks. These efforts include collaboration
with the World Bank and other partners on structural issues, advice and
assistance on implementing supporting macroeconomic reforms, and increased
flexibility of Fund-supported programs. In particular:

The IMF works in collaboration with the World Bank and other development
partners to ensure that IMF-supported programs incorporate structural
reforms that reduce bottlenecks in the economy and improve its flexibility,
especially by increasing the pool of skilled workers available to provide
services in health and education.

IMF policy adviceincluding in the context of lending programsoften
recommends measures to improve both the composition and efficiency of
spending. Higher public spending is not sufficient for achieving sustainable
growth and poverty reduction. For example, in many countries the benefits
of government spending on education and health accrue largely to richer
income groups, so that increased general allocations of funds for these
sectors do little to alleviate poverty. Instead, measures need to be taken
to better target the education and health benefits to the more disadvantaged
members of society, including those in rural areas.

The IMF also encourages countries to undertake reforms that improve the
transparency of their fiscal systems, thereby making governments more
accountable to their constituents for the use of grant resources. In particular,
the Fund recommends that external grants be channeled through the budget.
This enables a country's authorities to allocate all resources under the
government's control according to the country's own priorities-as established
in its Poverty Reduction Strategy Paper (PRSP)and after assessing
the tradeoffs among competing demands for funds.

The Fund often supports its policy advice with technical assistance (TA)
to provide training to government officials and help them to implement
needed reforms. TA is provided on a wide range of fiscal issues, including
budget formulation, tax and customs administration, public expenditure
management, and the design of social safety nets. TA is also provided
to assist with statistical reforms and to help countries adopt international
standards and codes, including in the area of fiscal transparency.

Finally, the IMF works closely with member countries to incorporate additional
external resources into Fund-supported programs. The Fund has been criticized
for not allowing spending to increase by the full amount of an increase
in grants or concessional lending. In fact, IMF-supported programs do
not have a ceiling on the amount of external assistance that can be
spent, and programs have increasingly supported higher expenditures in
recent years (see Box 1).2

Box 1. External Grants in Fund-Supported
Programs

Fund-supported programs have increasingly accommodated
higher external assistance, including grants. A review of recent
programs in low-income countries* found that average external assistance
(including both grants and concessional loans) has increased under
the IMF's concessional lending program-the Poverty Reduction and
Growth Facility (PRGF). In the first year of PRGF-supported programs,
average external assistance was about 7 percent of GDPsome
1 percent of GDP higher than in the year preceding the program.
External grants rose by more than ½ percent of GDP to 4 percent
of GDP during the first program year. Increases in grants were especially
sharp in Malawi and Uganda (over 2½ percentage points of
GDP).

Increased external assistance has been accompanied
by increases in public spending. Deficits excluding grants (see
Box 2) were, on average, ¾-percentage point of GDP higher
than in the pre-PRGF year. Expenditures rose by almost 1 percent
of GDP, on average, and by even more in countries receiving larger
increases in grants; in Uganda and Malawi, government outlays rose
by 3 percent of GDP and 5 percent of GDP, respectively. Budgets
also became more pro-poor, as the share of poverty-reducing outlays
in government spending increased an average of 5 percentage points
under PRGF-supported programs.

The presumption in Fund-supported programs under the Poverty Reduction
and Growth Facility (PRGF) is that they will accommodate additional aid
inflows for financing poverty-reducing spending and achieving the MDGs.
As discussed in Box 2, the IMF normally considers two measures of the
deficitinclusive and exclusive of external grants. Projected grant
levels are built into the formulation of program targets. In cases where
an unexpectedly high grant inflow can be readily absorbed, the programs
generally provide for adjusters to deficits that allow for higher-than-targeted
expenditures and higher-than-targeted deficits (excluding grants). In
the case where absorptive capacity is weak or the magnitude of inflows
poses a threat to macroeconomic stability, the IMF would counsel the country's
authorities about compensatory measures that could reduce the risks. For
example, a country might be advised to cut other, less productive spending,
in order to partially offset a grant-supported increase in spending on
HIV/AIDS. Or, it might be counseled to spread the increase in spending
over a longer time period in order to facilitate a more gradual impact
on the labor force. But, ultimately, these decisions must be made by the
country's authorities.

Box 2. The Accounting Treatment
of External Grants

Fund-supported programs typically focus on two measures
of the fiscal deficit, including and excluding grants. This accounting
treatment allows for significant flexibility in accommodating higher
external grants.

The fiscal deficit measured "including grants"
would be based on total revenues, including tax collections, grants,
and other non-tax revenues. In this case, the fiscal deficit would
be calculated as total government spending, less total revenue.
The second measurethe fiscal deficit "excluding grants"would
use total revenue excluding grants in place of total revenue.

To illustrate the flexibility of these two approaches,
consider a simple numerical example where, under a Fund-support
program, a government collects $18 million in taxes, $2 million
in non-tax revenues, and it undertakes expenditures totaling $23
million. The fiscal deficit, under both measures, is $3 million
(first column labeled "Original Program").

Now, suppose this government receives a $4 million
grant, which was not envisaged under the program and may be used
to fund general expenditure. How might the program accommodate these
higher grant inflows? Depending on the country's macroeconomic situation
and absorptive capacity, the program could accommodate the full
amount, as indicated in the second column. Under this scenario,
the fiscal deficit (excluding grants) would be higher by $4 million,
but the fiscal deficit (including grants) would be unchanged.

Original Program

Program Accommodating Full
Amount of Grant Received

Total spending

23

27

Tax revenues

18

18

Non-tax revenues

2

2

Total revenue (excluding grants)

20

20

External grants

0

4

Total revenue (including grants)

20

24

Fiscal deficit (excluding grants)

3

7

Fiscal deficit (including grants)

3

3

In a country where absorbing the entire amount of
additional grant inflows would be difficult, the authorities and
the IMF may agree that the program should accommodate less than
the total amount available in the current year.

Both measures of the deficit are normally considered
when designing or adjusting a macroeconomic program, with analysis
informed by what is known about absorptive capacity and the likelihood
that the grant flow will be of a recurrent, sustainable nature from
donor sources. In general, it is sensible to put more weight on
the "fiscal deficit including grants" measure when grant
flows are likely to be recurrent and stable. Conversely, if there
is a significant risk that a grant stream will be volatile, it would
be prudent to put more weight on the "fiscal deficits excluding
grants" measure. The same reasoning would apply to the treatment
of any source of revenue; any volatility of resources must be taken
into account in budget planning.